DIY Rental Property Accounting for Lower Taxes

An example of a fully depreciated rental property. Newark castle, England. CC-SA by Clydecoast.

Bookkeeping is the Bedrock

The foundation of any rental real estate tax savings is a monthly close. This means shortly after the end of each month, record each income and expense in a general ledger and reconcile your ledger to bank and credit card statements. A receipt should accompany each expense. Income should be attributable to each tenant. Each item in your bank and credit card statements should have a separate record in your ledger.

You have options when it comes to a general ledger. If you roll old-school, you can record income and expenses using parchment and a freshly sharpened quill. Record each entry “double entry,” so that every line corresponds to a transfer between accounts. For instance, spending at Home Depot is a transfer from your coin purse account to your expense account.

If you have a Windows computer, and if you dislike the idea of storing your financial records on the Internet, you can’t beat the free Microsoft Money Sunset Edition. Although no longer supported, it still works. It’s fast and easy to learn, and customizable.

If you value data backup and accessibility from the road, there are cloud-based options in QuickBooks Online (generic business ledgers) and Buildium, Appfolio, and Yardi (real estate specific). There are also app-integrated services like Simple that will push a notification to your phone each purchase to let you categorize it there at the store, no receipt required.

Be Glad Your House is Depreciating

When we say your house is depreciating, don’t take offense! Depreciation is a tax concept separate from “falling apart.” But the two are related. The IRS assumes that when you buy a property, its value will decline to zero over a long time. For a residential property, for instance, they assume a service life of 27.5 years. This implies huge tax savings for owners.

Suppose you buy a rental property for $375,000. The value of the underlying land, which does not depreciate, might be estimated at $100,000. This leaves $275,000 divided by the service life of 27.5 years that you can write off on your taxes each year ($10,000 of write-offs). If you are in a 25% tax bracket, this equates to $2,500 less in taxes, each year, just because you bought the rental property.

The IRS says they will claim this back when we sell the property. This is a “recapture” tax. But we don’t have to sell during our lifetime. And there’s also a thing called a “Section 1031 exchange.” This re-investment process lets us sell and buy another rental property, and defer the recapture tax indefinitely, as often as we need to grow our business and further support the economy.

Cost Segregation

You can depreciate your house over 27.5 years, but if you have extra time to tinker, you can segregate things inside the house that have shorter useful lives. The IRS allows machinery and appliances to be depreciated over five years, and everything not listed can be depreciated over 7 years. This can accelerate your tax savings, and for larger acquisitions can more than pay for your time to do it.

Repairs vs Improvements

When you patch a leaking pipe, the IRS says you have “repaired” it. When you replace a broken pipe with a new pipe, the IRS says you have “improved” your plumbing.  Repairs are expensed in the tax year in which they are made. Improvements must be depreciated.

When you record income or expenses in your ledger, note whether the expense is part of a repair or an upgrade. This greatly simplifies tax time. You might consider having no categories other than “repair” and “improvement” for physical changes to the property. In other words, don’t categorize this expense as “plumbing” and that as “carpentry.”

Note that the IRS is wise to us wanting to make a hundred small repairs at the same time and expensing it all right away. They call this a “general plan of improvement” and require us to depreciate all the minor repairs at once.

Note that depreciation timelines for upgrades can be long. Anything attached to the building must be depreciated over a 27.5 year timeframe, just like the building itself. The IRS does this to enforce tax collection sooner. The benefit to owners is a kind of “forced tax savings plan.” Your long-term tax liability will be lower now and decades from now.

Everything is a Business Expense

Many more things can be deducted than people generally realize. MassLandlords membership dues and event tickets, for instance, are deductible as training and seminars. Holiday decorations are supplies. Home office space and personal auto use can also be apportioned and deducted. Be very careful! All expenses must have a reasonable and customary business purpose. And some deductions, like the home office and personal auto deductions, carry the risk of automatic audits under some circumstances.

Smoothing the Books

You might pay your insurance premium for 12 months in advance in order to save money. If you pay this in November, it will make November look like you lost of a lot of money. This is the drawback of accounting on a cash basis.

If you want to get fancy, you can move toward accrual accounting. Instead of recording the insurance premium in your bank ledger as an expense, transfer that money to a “prepaid insurance” account. In the “prepaid insurance account,” you will enter 12 monthly debits equal to your premium. This will make November look like a normal month, as every month will show its fair share of insurance expense.

You can extend this idea to create a new account for each depreciable improvement. For instance, if you renovated the bathroom in Q2 2017, you can transfer all those expense entries to a “2017 Q2 bathroom” account, and each year add a depreciation entry according to the IRS tables. Your tax time will be a breeze!

Apportioning Personal Use

If you live in your rental property, or if you treat it as a vacation home that you use for part of the year, then a portion of the expenses of that building are not deductible. For instance, if you have personal access to one-third of the rental property because you live on the second floor of a three-decker, then only two-thirds of your ledger expenses can be filed as deductions. You can still claim one-third of the mortgage interest on your personal taxes like a normal homeowner.

Vacation properties require us to calculate how much of the year we spend there. If we spend one week out of 52 in a year, then fifty-one fifty-seconds can be filed as deductions.

The actual math requires more calculation than this. Consult with the Nolo book, recommended below.

Where do Rental Taxes Get Filed?

If you own the properties in your own name, they will be filed on your Schedule E (page 1). If you own them under an LLC and you’re the only LLC owner, they will still appear on your Schedule E. If you are a partnership, LLC with two or more owners, or S Corporation, that entity will file a form 8825, give you a K-1, and you will record that number on your Schedule E (page 2 instead of page 1). C corporations pay taxes directly and do not pass rental income to your personal return.

Rental Property Tax Conclusion

Nolo’s “Every Landlord’s Tax Deduction Guide” is a comprehensive resource, and so good we give it out as part of our “Crash Course.” Remember to always consult with a CPA before taking action based on anything you read, whether this article or Nolo. Happy deducting!